UBS warns: US midterm elections may cause severe market volatility, current period is the "calm before the storm"

UBS Chief Economist Arend Kapteyn wrote in a research report on Wednesday: “This could be the calm before the storm.” He pointed out that with the U.S. midterm elections approaching, historically, market volatility has significantly amplified during this period, and this year is unlikely to be an exception.

Citing data, Kapteyn noted that since 1928, September to October have been the most volatile months of the year—regardless of whether it’s an election year, volatility climbs during this period and then drops sharply afterwards.

The betting odds for Senate control are currently near even, and Kapteyn believes, “There’s almost no reason to believe this year’s uncertainty and volatility will be lower than in previous midterm election years.”

Historical Pattern: Falling Before the Election, Rising After

Data shows that in midterm election years, the S&P 500 typically falls between late August and early October, but by the following March, the average return is about 14%, with the median return as high as 16.4%.

In comparison, the average return for the same period in non-midterm years is less than 5%.

There are exceptions to this pattern: the inflation shock of 1978, the bursting of the tech bubble in 2002, and the 2018 trade war combined with Federal Reserve tightening all broke the post-election rebound tradition.

Loss of Seats by the Ruling Party Is the Norm, Congressional Situation Uncertain

Kapteyn cited historical data showing that since 1950, the ruling party has lost an average of 25 House seats and 3 Senate seats in midterm elections.

JPMorgan’s Andrew Tyler also shared his base case with clients: integrating data from 23 midterm cycles since 1934, the ruling party on average loses about 27 House seats and about 3 Senate seats.

Applying historical patterns to the current situation—Republicans hold a majority of 218 seats in the House, and lead in the Senate 53 to 47—the forecast points to Democrats retaking the House and Republicans keeping the Senate.

Betting market data confirms this assessment: Kalshi data shows that the probability of Democrats retaking the House is as high as 85%, but Republicans retaining the Senate stands at only 53%, meaning the situation is quite close. Polymarket data shows the market has priced in a high probability that Democrats could sweep both chambers.

Wall Street Institutions Issue Warnings

Bank of America strategist Michael Hartnett expects that if Democrats sweep both chambers, the market will experience a sharp sell-off.

Traders’ concerns are focused on policy: Democrats have signaled that they could push for stricter regulations and a pause on data centers, both seen as direct threats to AI-related assets.

Kapteyn ends his report with the question again: “Calm before the storm?”